Wage Inflation Does Not Just Explode

Monday, 05 May 2014 05:14

The NYT had an interesting piece presenting the argument that the Federal Reserve Board should focus on wage inflation rather unemployment, not beginning to tighten up until wage inflation started to get above 3.0-4.0 percent, a rate consistent with its 2.0 percent inflation target. The piece included a counterargument from Torsten Slok, chief international economist at Deutsche Bank Securities, that if the Fed waited until it saw rising wage growth it would be too late. Inflation would then already be too high and getting out of control.

It is worth noting that there is no data to support Slok's view of inflation. Standard analyses show that the rate of inflation increases very slowly even in an economy where unemployment is below the level consistent with a stable inflation rate (i.e. the non-accelerating inflation rate of unemployment or NAIRU). According to the Congressional Budget Office, even if the unemployment rate is a full percentage point below the NAIRU for a full year the rate of inflation would only rise by 0.3 percentage points. This suggests that there would be very little risk in terms of higher inflation from delaying Fed tightening.

Although the two central bankers cited in this piece have opposing viewpoints regarding wage inflation it's worth noting that they both agree: "...that the greater risk is in failing to do enough about unemployment." Which puts them ahead of most of Congress.

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Wage Inflationwritten by jonny bakho,
May 05, 2014 9:12

Wage inflation of at least 4% is needed to reset relative prices and catch up from the wage deflation and too low inflation of the past 5 years.

It is not a problem if wage inflation surpasses 2 percent. Think of it as part of the solution.

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targeting unemployment ratewritten by Pouya,
May 05, 2014 11:20

Hi Dean, thanks for the insightful post. I got a question for you. Economists like Milton Friedman argued that when Fed targets lower unemployment (and higher inflation) in the long run there is no trade-off between inflation and unemployment (due to wage inflation like in the 70s resulting in stagflation) and hence central banks should not set employment targets above the natural rate. What is your view on this? I understand that this is not consistent with what happened during the 90s (unemployment going lower than NAIRU while inflation stayed low), but theoretically what is the flaw in the argument?

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Pouya, what people think Milton Friedman thought vs what he thought matters.written by jaaaaayceeeee,
May 05, 2014 5:50

Krugman has done a lot blogposts to debunk austerianese and other mis-applications of economic theories.

Dec. 20, in his blogpost "Mocrofoundations and the Parting of the Waters, Krugman writes:

... As Phelps and others (including Milton Friedman, who was thinking along similar lines) realized, this meant that the apparent tradeoff between unemployment and inflation would be unstable: sustained inflation would get built into expectations, and would no longer produce low unemployment. The stagflation of the 70s seemed to confirm this prediction, and brought the microfoundations project immense prestige. Encouraged by all this, freshwater economists gleefully proclaimed Keynes dead, the subject of nothing but “giggles and whispers”... "So the truth was that microfoundations in macroeconomics had its moment, but failed utterly at the one thing it was sold, above all, as being able to do – namely, give a better explanation of why nominal shocks have real effects. Time, you might think, to reconsider the project. And some did"...

"Friedman’s success, with Phelps, in predicting stagflation was what really pushed his influence over the top; his notion of a natural rate of unemployment, of a vertical Phillips curve in the long run, became part of every textbook exposition. But it’s now very clear that at low rates of inflation the Phillips curve isn’t vertical at all, that there’s an underlying downward nominal rigidity to wages and perhaps many prices too that makes the natural rate hypothesis a very bad guide under depression conditions".

Krugman did a lot more posts in 2012 that you might want to skim. Try searching on "tradeoff unemployment inflation" and "stagflation" to get econ history that should answer your question.